A private corporation can elect to pay a “capital dividend” to its shareholder(s). The benefit of the election is that the dividend is not included in the shareholder’s income, assuming the shareholder is a Canadian resident (withholding tax will apply if the shareholder is non-resident). Public corporations cannot make the election.
In general terms, a capital dividend reflects certain amounts that are tax-free to the private corporation, and that should be allowed to pass tax-free to the shareholders. For example, one-half of net capital gains are not taxed and therefore form part of the capital dividend. More specifically, the capital dividend will reflect the corporation’s “capital dividend account” (CDA), which includes items such as:
- One half of the corporation’s capital gains in excess of one-half of its capital losses;
- Most life insurance proceeds received by the corporation on policies where it was the beneficiary; and
- Capital dividends that the corporation received from other corporations.
The CDA for the purposes of the capital dividend is computed immediately before the earlier of the time that the dividend became payable and the time it was paid. (It is usually payable at the time indicated by the directors of the corporation in the corporate resolution declaring the dividend.) Similarly, the corporation must file the CDA election with the CRA by the earlier of these two times. The election is filed on Form T2054. Late filing may be allowed, but with a monetary penalty.
Dividend exceeds CDA
Normally, the dividend will not exceed the corporation’s CDA, so the entire dividend is a capital dividend. If the dividend exceeds the corporation’s CDA but the corporation still makes the election, the entire dividend remains non-taxable to the shareolder. However, the corporation will be subject to a penalty tax of 60% of the excess amount of the dividend. As an alternative to the penalty, the corporation may elect to treat the excess amount as a taxable dividend, meaning that the shareholders will include that excess amount in income as a dividend.